Market Outlook: China's long-term growth in jeopardy

17 January 2013 19:51[Source: ICB]

In the best of all possible worlds, most of China's 1.3bn people will quickly become "Western-style" consumers of the vast array of finished goods made from chemicals and polymers. Although it has made great progress since 1991, China still has a long way to go before reaching Western income levels.

Last February, China sceptics, who had long argued that it was wildly optimistic to hope that China would rapidly become a Western-style economy, were given official support through the publication of a World Bank/Chinese government report.

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If China builds it, will they come?

While attempting to strike an optimistic tone, the report - China 2030: Building a Modern, Harmonious, and Creative High-Income Society - seemed to suggest that China might never realise the dream of many chemicals and polymers producers.

The report said that China needs to:

Complete the transition to a market economy.

Accelerate the pace of open innovation.

"Go green" in order to transform environmental stresses into green growth as a driver for development.

Expand opportunities and services such as health, education and access to jobs for all people.

Modernise and strengthen its domestic fiscal system.

Seek mutually beneficial relations with the world by connecting China's structural reforms to the changing international economy.

We will look at these challenges in detail in later articles. Here, though, we will focus on what the World Bank also discussed in the same report - the need for China to fix its risky addiction to investment as a driver of growth.

"Depending on precise assumptions, over this period (2007-2011), China may have been over-investing by between 12% and 20% of GDP relative to its steady-state desirable value," wrote the International Monetary Fund (IMF) in a November 2012 report .

"Even allowing for elevated investment levels associated with most economic take-offs, the econometric evidence suggests that China is over-investing," it added. "China's predicted investment norm over the last 30 years has ranged between 33-43% of GDP. In reality, it has fluctuated in a much broader band of 35-49% of GDP."

The IMF worries that Beijing could be tempted to stick to the investment growth model, resulting in investment's share of GDP rising to as much as 70%.

"Under such a strategy, vulnerabilities will likely grow in the form of hidden deadweight that will have to be paid in the future in one form or another. The cost of financing such an elevated level of investment could undermine overall economic stability," the report continued.

That might be a diplomatic way of warning that, unless China stops misallocating capital on "white elephant" infrastructure and industrial projects, it might face a financial sector crisis as more debt turns bad.

As we have discussed before in this column, the property sector is weighed down by bad debts, with excess capacity acrossmany industries.

The scale of credit expansion in 2009-2010, when China poured money into the economy in order to compensate for the global financial crisis, has in particular raised a lot of concern

"While previous financial crises don't show a very consistent relationship between the scale of credit growth-to-GDP and the scale of the subsequent crisis, research compiling 42 crisis episodes shows that average annual credit growth to GDP was 8.3% preceding these events," wrote the FT Alphaville blog in a 28 August 2012 post. "China's [credit growth] growth was 27.9% in 2009 and 20% in 2010."

In an ostensibly centrally controlled economy such as China's, one might think that it would be relatively easy to turn off the credit tap by ordering the state-owned banks to lend less money.

Evidence to support this notion was the sharp reduction in the lending quotas of state-owned banks in 2011.

SHADOW BANKING

But there is growing anxiety over China's shadow-banking system, which comprises both privately owned lenders and wealth management products (WMPs) sold by the state-owned banks. WMPs have so far not been included in central government lending quotas, whereas private lenders are numbered in the hundreds of thousands so would be very hard to regulate.

WMPs are being sold to what several financial analysts fear are uninformed members of the public. The money raised from these sales is finding its way into commodities trading, including petrochemicals, and other speculative investments such as property.

Sound familiar? Yes, comparisons have been drawn with the build-up to the US subprime crisis.

Wang Tao, economist at global investment bank UBS, believes that the value of the shadow banking system is Chinese yuan (CNY) 13.6 trillion ($2 trillion), or about one-quarter of 2012's GDP, and could be as big as CNY24.4 trillion, or nearly 50% of last year's GDP.

The danger, of course, is if a lot of this debt starts turning bad.

All might be fine for the time being if, ironically, both the shadow and official lending sectors maintain credit flows, as bubbles can only remain inflated as long as more air keeps being pumped in.

PROPERTY BUBBLE

The property sector serves as a good example of a Chinese investment bubble.

Apartment values actually fall when someone moves into a building, so instead they are being kept empty and unused.

Land is obtained at a low price, or even free, from rural communities.

Local governments sell the land to the property developers.

The developers then sell the apartments, which never get occupied, but they do get traded and are used as collateral, even for petrochemicals trading.

"This explains why you can get current price/earnings ratios of 14:1 in China's Tier 1 cities, compared to a maximum of 5:1 at the peak of the US subprime bubble," said a UK-based financial analyst. "China has lots of land, and so theoretically the game can continue for years more. But only if there is still cash to fund the system."

Beijing might therefore be tempted to kick the can down the road, particularly this year as its new senior leaders, who took office November, are likely to want to shore-up popular support.

But, as we said earlier, the IMF has warned that the longer weaknesses with the investment growth model are ignored, the greater the eventual fall-out.

REFORMS TO COME?

Perhaps, though, China's new Politburo will forge ahead with white-hot reform. The Chinese government commissioned the World Bank report and one of its civil servants co-authored the IMF study. Recognising the problem could be half the battle.

However, reform would be bad news for GDP growth, according to Peking University professor Michael Pettis.

Pettis, in a 28 December post on his China Financial Markets blog, said that China needed to at the very least reduce investment as a percentage of GDP growth to 40% - from what he believes was 50% in 2012 - over the next five years.

"Chinese investment must grow at a much lower rate than GDP for this to happen. How much lower? The arithmetic is simple," he wrote in the same blog post.

"It depends on what we assume GDP growth will be over the next five years, but investment has to grow by roughly 4.5 percentage points or more below the GDP growth rate for this condition to be met," he wrote.

"If Chinese GDP grows at 7%, in other words, Chinese investment must grow at 2.3%. If China grows at 5%, investment must grow at 0.4%," Pettis added. "And if China grows at 3%, which is much closer to my 10-year view, investment growth must actually contract by 1.5%. Fixed-asset investment grew by 20.7% in 2012. Yes, 20.7%. This put the scale of the adjustment in perspective."